Reasons for market failure

Most markets are NOT successful, and the government intervenes to some degree

• Perfect markets are socially efficient, they are operating at Pareto optimality in which no one can be made better off with someone being made worse off (zero sum)

• Consumer surplus is maximized
• P=MC where MSC=MSB

• In the real world, markets are not perfect; MSC does not equal MSB and market failure occurs
• This is because of externalities, underprovision of merit goods, the overprovision of demerit goods, a lack of public goods, and imperfect markets
• If the free market is left to its own devices, Pareto market failure will occur

• Inefficient Producers: producers do not produce where the average costs are at minimum
• Therefore they are using more resources than they need to

• Positive and Negative externalities: an externality is an effect on a third party which is caused by the consumption and/or production of a good or service
• There are four types of externalities

• 
  Positive Consumption Externality
• 
  Negative Consumption Externality
• 
  Negative Production Externality

• Short-term and long-term environmental concerns, with reference to sustainable development
• Lack of public goods : public goods are goods which total cost of production does not increase with the number of consumers

Public goods are:
1. non-rivalrous (consumption by one consumer will not reduce the amount available for other consumers in the market, i.e. they do not have to compete to obtain the good/service)
2. non-excludable (no consumer is excluded from consuming such good/service)

• The classic example is national defence
• Other examples: street lights, roads

• Public goods will not be provided by the market

• Underprovision of merit goods: if left to its own devices, merit goods (a private good that society considers underconsumed, often with positive externalities) will be underprovided

• These are goods and services which have a positive effect on society like education, healthcare and sports centers

• Overprovision of demerit goods: if left to its own devices, demerit goods (a private good that society considers overconsumed, often with negative externalities) will be overprovided

• These are such things as prostitution, alcohol and cigarettes
• To discourage these demerit goods the government creates: negative advertising, tax on the good, or bans it altogether

• Abuse of monopoly power: imperfect markets such as oligopolies and monopolies restrict output in an attempt to maximize profit

• Thus, MSB is not equal to MSC / MSC is equal to MR

Possible government responses

• Legislation: antitrust legislation can be brought in an attempt to break monopoly power and collusive oligopolies

• Legislation to make high school attendance mandatory
• Ban smoking in restaurants

• Direct provision of merit and public goods: governments can control the supply of goods that have positive externalities by supplying a high amount of education, public roads, parks, libraries, etc.
• Taxation: place an excise tax on the sale of tobacco products or alcohol to discourage consumption

• This will internalize some of the external costs (i.e., smokers will pay for their second hand smoke through the tax)

• Subsidies: reduce the cost of university education because it has beneficial externalities

• The price will be reduced to reflect the benefit society attains through the education of individuals

• Tradable permits: tradable permits are permits allowing a firm to produce a given amount of pollution

• There is limited supply for how much pollution a firm can produce so if a firm would want to pollute more it has to purchase tradable permits from other firms
• A Carbon Tax (taxing consumption which causes pollution, such as fossil fuels) achieves the same result
• In both cases, firms and individuals are motivated to reduce costs by reducing environmental damage

• Extension of property rights: form of privatization to privatize certain non-private goods

• e.g., lakes, rivers, beach=> create a market for pollution and charge people if they want to pollute something

• Advertising to encourage and discourage consumption: by the government to ensure the social optimum level of consumption is being achieved

• International cooperation among governments: in the case of acid rain, for example international cooperation among governments is necessary in order to reduce its occurrence